Beyond Long-Only: How 130/30 SMAs May Rejuvenate Tax-Loss Harvesting

Beyond Long-Only: How 130/30 SMAs May Rejuvenate Tax-Loss Harvesting

Anu Rajakumar: Tax-managed equity investing has been around for decades, but in recent years, the playbook has evolved beyond traditional long-only approaches. Newer strategies like active extension or 130/30 aim to offset long positions with selective short positions, but the goal remains the same. Maximizing after-tax returns. By using an active extension approach, investors can seek higher alpha with the same level of beta or market volatility.

How exactly do tax-managed strategies like 130/30 work? What are the benefits and risks of adding modest leverage and offsetting short positions? How should investors think about implementation choices like funds versus separately managed accounts, active versus passive strategies, and even jurisdictional nuances beyond the US? My name is Anu Rajakumar, and today I'm joined by Ray Carroll and Jacob Greene. Ray is the CIO at Neuberger's Breton Hill quantitative investing team. Jacob is the Head Strategist for Custom Direct Investing at Neuberger.

Today we will dig into the practical, how it works of 130/30 tax-managed investing, what it is, where it can be most effective, and how to use it responsibly. Ray and Jacob, welcome to the show.

Ray Carroll: Thanks for having us.

Jacob Greene: It's great to be back.

Anu: Gentlemen, to kick us off, Jacob, can you explain what exactly 130/30 tax-managed investing is and how does it differ from traditional long-only tax-managed strategies?

Jacob: Sure. Tax-managed 130/30 portfolio, it's an enhanced long/short strategy where margin is used to expand the investment. Investors are typically used to 100% long equity portfolio. In this case, we're going to have 130% of the portfolio in stocks where we might expect to outperform. These are the long positions, and 30% in stocks we expect to underperform, the short positions. We're doing this by utilizing margin to increase the total exposure, but still have it net out. Effectively, you have 100% investment and a beta of 1.

Beyond the pre-tax benefit of doing this, of having these stocks that are going to outperform, there's a tax-managed design to it. We are holding individual stocks in the separately managed account. As prices rise or prices fall, we can then make decisions on whether to hold and defer a gain on a position where the stock has gone up or potentially sell it, harvest a loss, and receive potential tax benefit of selling this position that's gone down. We do this systematically on the portfolios from a loss harvesting perspective relative to long-only.

We now have more exposure to work with. You have 160% of market exposure. You're also less impacted by the market direction because, simply, if markets go up, we can loss harvest on the short side of the portfolio, markets go down, we can loss harvest on the long side in all cases, because you have single stocks. We know not everything moves in one direction. You can take advantage of the volatility among stocks. These portfolios can be really helpful in rejuvenating loss harvesting of existing portfolios as well.

You may have a portfolio you've invested, say, the last 10 years, where the market has been in a bull rally. Clients may be sitting on a good amount of gains. They may not be able to diversify in the way that they'd like to reduce risk and align with their target benchmark. Using these extensions can both help you offset some of the risk and build around your existing portfolio, also provide you some fresh positions for tax-loss harvesting so you can tax efficiently, get towards that target benchmark. We've spent a lot of time on the tax benefits. We really do view that as icing on the cake. You're doing this from a pre-tax perspective, but there are some really neat after-tax benefits that can be unlocked.

Anu: Absolutely. I love your focus on diversification and offsetting risk. Ray, anything to add to that?

Ray: Yes, I think there's an important point that I'll emphasize that Jacob raised for folks that are used to long-only tax-managed investing. That's that you really need to have a good pre-tax investment reason why you're taking all these actions. In other words, you don't just want to have a conversation with the IRS to say, "Yes, I took a long portfolio, I leveraged it to 1.3 times, then I borrowed stock and short sold it, and I did that all exclusively to lower my tax bill." All of our tax advisors say that's a bad conversation to have. You want to actually say you took all those actions because it builds a good portfolio, and it just so happens that we can implement it in an extremely tax-efficient way.

That suits us very well, because Neuberger Berman is an active shop. The majority of our team strategies are active. In fact, the majority of our tax-managed strategies at Neuberger Berman are actually active. We're very accustomed to building active strategies, which we then implement from a pre-tax basis. Our general approach to active management is this, let's build quantitative models where we have two key objectives.

One objective is to incorporate as much fundamental insight into our models as possible. In that effort, we're supported by our 50-person fundamental team. Then secondly, how do we get as many alternative signals that help support 10k and 10Q type information into our models, whether that's supplementary credit card transaction data, natural language processing of earnings calls? We put all that information together to try and identify stocks for the long side that we believe have the best outlook, and for the short side, the worst outlook.

Anu: Absolutely. I really like that reframing of the big picture objective of why we're doing that. Jacob, if folks heard that intro and something has piqued their interest, if they want to access 130/30 today, what are actual, practical paths to do so, active versus passive, you mentioned a separately managed account, how does that differ from a fund vehicle? Explain why does the vehicle choice matter in that tax aware context?

Jacob: In terms of the active/passive, it really needs to be active. You have to be taking some active stock bets in doing this. It's not a passive vehicle in any ways. In terms of how you implement, we're implementing through separately managed accounts. Why are we doing that? Because when you talk about building custom equity exposures, when you're talking about tax management, it's really hard to have multiple investors aligned with the same timeline, the same objective, the same funding source. It's really important that we have these individual separately managed accounts where we can have one for Anu, one for Ray, where your cost basis, your funding, your objectives are captured and managed.

That really is what allows us to build these as meaningful investments. From an operational perspective, it really is similar to any other separately managed account, with a few differences in that you are using margins. Maybe there's a little bit more paperwork, there's certainly some more education to spend time with on the investor, but at the end of the day, you are ending up with an account that you have full transparency into and that you can monitor day in, day out.

Anu: Great. Just to summarize, you said it needs to be customized, it needs to be actively managed, and a separately managed account is the right vehicle for that. Now, let's maybe bring this all to life. Ray, could you possibly walk through a scenario where 130/30 helps to, I think, as Jacob said before, rejuvenate that tax-loss harvesting in maybe like a long tenured, highly appreciated portfolio that I think many people have thankfully experienced over the last number of years. What does that actually look like in practice?

Ray: Sure. I'll tell you the story of our very first tax-managed client who we started working with a decade ago. They're now our very first long/short tax-managed client. The background there is that over the past 10 years, it's been a terrific time for equity investors. If you had invested in the S&P 500 10 years ago, you have nearly four times the market value that you had at the time of investing. The reality is there's simply less losses to harvest now that your overall market value has gone up by four times. If you actually switch over from long-only to 130/30, now, two things happen.

On the long side, you now have a fresh 30% with a fresh cost base that allows more harvesting on the long side. Now you also are introducing a short side where if markets continue to go up, you can harvest that short side, because keep in mind that you have losses on the short side when markets rise. That's a way to rejuvenate losses and a really good use case for 130/30. I do want to address one thing, though. Even though loss harvesting decays through time on a long-only framework, that's still not necessarily a bad thing.

The way investors should think about it is, in the early years, you do more aggressive loss harvesting, but the reason why that's valuable is it means you can lower your tax bill, keep more money invested, and that more money invested compounds over time. Even in the long-only case, you're still getting that benefit of compounding all the taxes you didn't pay in the early years. It still can be valuable, but 130/30 gives you a chance to really rejuvenate the loss harvesting on top of that compounding effect.

Jacob: One other example that I might throw out there of use cases here is some clients, as they're preparing for large taxable events, we had one client approach us, they were preparing for a business sale coming up. This is going to be a very large and outsized amount of gains that they're realizing it's also going to be a great liquidity event where they're starting to build out the rest of their investment allocation.

As a way to start planning for that, they're going to start using a 130/30 portfolio. This gets them public markets exposure. There's the alpha signal that's going to help them outperform, but the tax-loss harvesting alongside that will build up. They'll keep and accumulate those losses so that when they do realize this event, these losses can be used to offset the gains from that, and that will allow them to keep more wealth and invest more wealth in the markets, so as Ray mentioned, can grow and compound.

Similar conversations happening. Ray mentioned the big market rally we've seen. A lot of investors are left with some very sizable concentrated stocks. You can think particularly the tech stocks. Everyone loves the story of the way that they've accumulated this wealth, but we all know diversification can pay off over the long-term. It can be really risky holding one single stock, but you also have to realize that you probably bought that at a low price and facing a large tax bill. What do you do? How do you help the client get out of that?

Putting them on a tax-efficient journey out of it is a good way to remove that barrier and say, "Let's get you towards diversification." 130/30 can help do that. You can use the extensions to help offset some of the risk day one, so you're immediately getting some diversification. Then, over time, you realize those losses, use that to sell down the position and start week by week, month by month, having less exposure, resulting in a diversified portfolio.

These are two examples. Examples that come up fairly commonly with advisors that we're talking to. When you put them all together, it's really having a broad toolkit to be able to use each of these and address each client need in a scalable fashion. It's not just solving one problem, but having the right tool for each solution.

Anu: You've outlined a strong value proposition thus far, but I do want to briefly touch about risks. Jacob, you mentioned margin and some administrative elements, and I know leverage can be a sensitive topic for some investors. Ray, maybe you can detail what risks tend to be underappreciated and how do you use 130/30 responsibly in terms of limits, guardrails, ongoing monitoring, et cetera.

Ray: What I worry about is if 130/30 is good, then what about 150/50 or 200/100 or 300/200? We do have clients coming to us and asking for some large numbers. I have a colleague that once gave this quick example, which is you put a little bit of salt on your meal and it tastes better, but you pour the whole shaker on it and your meal is ruined.

Anu: That's a great one. I haven't heard that before.

Ray: [crosstalk] I feel like [unintelligible 00:12:28] is a little bit like that. What I worry about is higher use of leverage where it's not needed. What I want folks to be aware of is that here we're talking about cases where high-net-worth investors are typically the end user in direct SMAs. That's an investor group that might not have as much experience with use of leverage as institutional investors. We should also keep in mind that the source of the leverage is coming from very strong firms, but not the traditional prime brokers that we associate with leverage.

Then we all have to keep in mind that whenever there's been a financial incident, you can almost always follow the breadcrumbs to overuse of leverage. I do want to caution folks, but we nevertheless do have some clients where we've offered higher leverage levels. Where we think it makes the most sense is when you have a specific time horizon where you really need to capture maximum amount of losses. That could be, for example, that you're selling your family business and you know that at the end of this year you're going to have a really large capital gain and you're in a bit of a race to really offset that with as many realized losses as possible.

That's what I would see as a high-quality reason to responsibly use higher leverage levels because it's worth the trade-off of higher vol. For other clients that sometimes ask us about higher leverage levels, I like to ask them, you're probably going to get three times as much loss harvesting as you would've with long-only, let's walk through your use case and make sure that that's not enough. In many cases it actually is. If it is, then you can really proceed with 130/30 levels without having to get special portfolio margin from your broker, which they can pull at any time. You're less exposed to any regulatory changes like we saw around short selling back during the 2008 crisis.

You are unlikely to find yourself in the position where you have a surprise drawdown because volatility is a little higher than you expected, and you're forcing to de-risk when you're less exposed to others de-risking that might be using the same provider that you are and following a similar model, which we saw happen during the quant quake back in 2007, albeit with higher leverage levels. All of those scenarios that I just outlined, by the way, they're all landing in one direction, which is you really want to avoid forced unwinding of your positions because the whole value here is all about deferring your taxes, defer, defer, defer so you can keep more money invested and let it compound.

You really want to get away from any situation where you have forced early liquidation before you really get to realize the long-term benefits of a tax-efficient strategy. It's a tough question, Anu, that's delicate to answer, but what I'm trying to balance is 130/30 is a prudent level where you can control vol very nicely. To go beyond that, I feel like you need to have very special and specific reasons why you need to.

Anu: No, I appreciate you laying that out and saying more is not always better, but perhaps it is in very select circumstances. Continuing with you, Ray, beyond the US, how do jurisdictional differences, tax rules, shorting mechanics, fund structures, et cetera, how does that change the way that you implement 130/30? I'll ask you, as the resident Canadian amongst us today, if you could answer that question.

Ray: Neuberger Berman is obviously a global firm, and we're in an interesting position where about 40% of our tax-managed assets are actually outside the US. We do run this business in a meaningful way globally, in particular in Canada. There are other jurisdictions where rules are amenable, Australia, UK, Denmark. The way we've thought about it is, let's make sure we can build the systems to handle the tax nuances and the specific rules in each jurisdiction so that you can offer clients in those jurisdictions a homemade product that really matches how they're going to file their taxes.

Anu: Yes, absolutely. Of course, 130/30, this tax-managed approach is not just a US phenomenon. It's something that can obviously be applied across markets globally. Jacob, maybe bring this back to you. Let's wrap this episode up, and tell us how advisors should decide when 130/30 might be the right strategy versus just sticking with a long-only tax-managed approach. What signals or client circumstances do you think really tip the balance?

Jacob: We've talked about all the great aspects of 130/30. To your point, it's not the only thing we offer, it's not the only thing we think is right for investors. It really is aligning the use cases with the outcomes that the strategy can present. It can be a powerful tool in those situations. The first thing is advisors need to evaluate the investor profile. Is someone interested and able to accept some more risk to try and outperform the market? Do they have the needs from a tax management perspective to need to get these losses, or are they solving a specific problem of diversifying a concentrated stock, preparing for a business sale?

Really determining that, making sure the client does have a long investment horizon, these are not tactical strategies. These are meant to be long-term investment allocations. Finally, as Ray outlined the risks of leverage, just making sure clients are comfortable from that. The last thing you want is a client who invests and very quickly realizes that's not something they're comfortable with. Those would be the things to think about.

If you step back more broadly, for an advisor who's building a business working across multiple clients, it's making sure you have a toolkit to offer the right solutions. Offer long-only tax management for those clients that are looking to defer capital gains, that are looking forward to some future event, whether it's charitably giving, passing through the estate, something where deferral works really well, consider leverage, consider expanding it for clients who do have more of those specific use cases. There are also other tools to bring in. We have option solutions, others that can be more tactical or solve more specific problems, but for an advisor, making sure that you have this whole toolkit, allows you to not force clients towards one product. Instead, to be consultative and align with each client's objectives.

Anu: That's an excellent way to wrap up the episode. Jacob and Ray, before you go, I do have one quick bonus question for each of you. We are approaching the end of 2025, and for me personally, this is a time of reflection and also gratitude. I'd love to know what's one moment from this year that you are particularly grateful for and why did it matter to you? Jacob, I'll ask you first.

Jacob: Sure. It was a great year. My wife and I celebrated our 10-year wedding anniversary.

Anu: Congratulations.

Jacob: Thank you. We celebrated with a trip to Croatia. Being able to get away, experience something new together, spend time out of the office for a little bit, spend time in the Adriatic Sea. Getting away, spending that time was really meaningful.

Anu: Oh, that sounds lovely. Very nice. Ray, what about you?

Ray: For me, I had a special moment in June when my daughter got married to a terrific fellow.

Anu: Oh, that's great. Well, congratulations to you as well. That must have been very special. What a great year for both of you. As we summarize today's episode, today, we explored how 130/30 tax-managed strategies can be a powerful tool in the toolkit to enhance after-tax outcomes. Again, this is by pairing selective shorts with a disciplined long exposure. We talked about implementation choices, the importance of having a customized and active separately managed account to implement this type of a strategy. We discussed risk controls, and I really liked, Ray, your analogy of not putting too much salt on your food, but just enough.

We also discussed and recognized the global applicability of this type of a strategy as well as nuances that may be present as we look to offer this to clients around the world. Jacob Ray, thank you so much for joining us today.

Jacob: Thanks for having us.

Ray: Thank you, Anu.

Anu: To our listeners, if you've enjoyed what you've heard today on Disruptive Forces, we encourage you to subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces, where you can find previous episodes as well as more information about our firm and offerings.

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